The Best Stocks to Buy and Sell

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A year or so ago, you'd have been a genius if you'd bought energy stocks and sold financial stocks. Among the stocks of the S&P 500, the energy sector is up 10% over the past year, while financials are down an abysmal 48%.

If only we knew.

An investing tool worth its weight in oilSome of us did know. Our Motley Fool CAPS database offered invaluable guidance on a number of stocks in both the financial and energy sectors. For example, despite Fannie Mae's(NYSE:FNM) impressive return of 38% from July 21, 2006, to July 21, 2007, our CAPS community gave the company just one star back in July 2007 -- the lowest rating possible.

As we all know now, the mortgage giant has seen its shares decline by more than 75% in the year since then. The following table shows similar results for Freddie Mac(NYSE:FRE) and MBIA(NYSE:MBI).

CAPS offered up equally useful insights on several energy stocks. For example, Petroleo Brasileiro(NYSE:PBR), commonly known as Petrobras, delivered outstanding returns of 70% from July 21, 2006, to July 21, 2007.

Our community gave the company a five-star rating a year ago, and Petrobras went on to achieve 71% returns in the subsequent year. The table below tells a similar story for Chesapeake Energy(NYSE:CHK) and Transocean(NYSE:RIG).

Five-Star Stocks From Last Year

Company

Year-Ago CAPS Rating (out of five)

One-Year Return Prior to July 2007

One-Year Return Since July 2007

Chesapeake Energy

*****

29%

54%

Petroleo Brasileiro

*****

70%

71%

Transocean

*****

55%

35%

Data from Motley Fool CAPS and Yahoo! Finance as of July 21, 2008.

Ultimately, our CAPS community had 20/20 foresight when it came to this very small group of energy and financial stocks. Don't get me wrong, however. CAPS didn't always get it right for each individual five-star stock or one-star stock. What we're finding so far is that our CAPS rating appears to have predictive capabilities across an average of all stocks within a given "star" portfolio.

The value, dear Brutus, is in our starsAcross the approximately 5,500 stocks in our database, there is striking evidence of the predictive nature of our CAPS rating. My colleague Tim Hanson first wrote about our returns data back in November. Below I've provided updated returns on a portfolio of stocks with a particular star rating:

Stock Group

Annual Return

Beta

Five-Star

12.1%

1.14

Four-Star

7.1%

1.11

Three-Star

0%

1.08

Two-Star

(5.0%)

1.04

One-Star

(11.4%)

0.79

SPDRs(AMEX:SPY)

(0.1%)

1.00

Internal data from Nov. 6, 2006, to July 3, 2008.

The table provides returns for each star category as stocks come in and out of that particular rating. Returns are calculated on a forward-looking basis for those stocks that are in the particular "star portfolio."

As you can see, despite all of the recent market turmoil, five-star stocks outperform the market by 12%, while one-star stocks underperform by roughly 11%. According to this data, investors would do well to look for new ideas among five-star stocks, while potentially unloading one-star stocks.

Keep in mind, though, that these returns are for an average of each star-rating, so you'll still need to do due diligence on specific five-star stocks. (In other words, this information can inform your research -- it's not meant to replace it.)

Getting in on the ground floorSo how can you benefit from this information? The easiest way is to utilize our CAPS screener to identify five-star stocks for further research. By looking for winners among a portfolio of stocks that outperform the market -- that is, by fishing in a richer pond -- you might increase your odds of success considerably.

So join our free CAPS service today and take our screener out for a spin. As the database gets smarter, the relative performance of our ratings should get even better. And that will be great news for ordinary investors.